Lecture 7

Leasing

1
Learning Outcomes
 Understand the different types
of leases.
 Understand how to evaluate the
lease vs. buy decision.
 Understand the importance of
tax rates in determining the
benefit of leasing.

2
Lecture Outline
 Types of Leases
 Accounting and Leasing
 The tax treatment of Leases
 The Cash Flows of Leasing
 NPV Analysis of the Lease-versus-Buy
Decision
 Debt Displacement and Lease
Valuation
 Reasons for Leasing

3
 Source: http://www.scmp.com/comment/insight-
opinion/article/2096508/hong-kong-will-gain-if-aviation-
leasing-takes-firms-must

Think

about it
To make HK the aviation leasing centre, there should be lessors willing to do this
business and lessees willing to lease rather than buy.
 How tax will affect the willingness of both parties to fall into leasing relationship? 4
 Types of Leases
 The Basics
 A lease is a contractual agreement between a

lessee and lessor.

 The lessor is the owner of the asset, who is entitled
to the lease payment for lending the asset.
 The lessee is liable for periodic lease payments in

exchange for the right to use the asset.

 Other terms: upfront payment; lease payment; who

will retain ownership of the asset and at what term;

cancellation provisions; the renewal options; the
obligations for maintenance and related cost.

Types of Leases 5
 Buying versus Leasing
Buy Lease
Firm U buys asset and uses asset; Lessor buys asset, Firm U leases it.
financed by debt and equity.
Manufacturer of
asset
Manufacturer of
asset

Lessor Lessee (Firm U)

Firm U 1. Owns asset 1. Uses asset
1. Uses asset
2. Does not use asset 2. Does not own asset
2. Owns asset

Equity
Equity shareholders Creditors shareholders Creditors

Types of Leases 6
Accounting and Leasing
 For lessees, the Financial Accounting
Standards Board (FASB) distinguishes
two types of leases based on the
lease terms.
 operating leases or
 capital leases (financial leases)

 And this classification determines

the lease’s accounting treatment.

Accounting and Leasing 7

Accounting and Leasing
 Operating leases do not appear
on the balance sheet.
 Capital leases appear on the

balance sheet—the present value

of the lease payments appears on
both sides.

Accounting and Leasing 8

Accounting and Leasing (Balance Sheet)
Truck is purchased with debt
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000

Capital Lease
Assets leased $100,000 Obligations under capital
lease $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

Accounting and Leasing 9

Capital Lease
 Because capital leases increase the
apparent leverage on the firm’s
balance sheet, firms prefer to have a
lease categorized as an operating
lease to keep it off the balance sheet.
 FASB provides specific criteria that
distinguish an operating lease from a
capital lease.

Accounting and Leasing 10

 Capital Lease
 A lease is treated as a capital lease if any
one of the following is met:
 The present value of the lease payments is at
least 90 percent of the fair market value of the
asset at the start of the lease.
 The lease transfers ownership of the property to

the lessee by the end of the term of the lease.

 The lease term is 75 percent or more of the

estimated economic life of the asset.

 The lessee can buy the asset at a bargain price at

expiry.

Accounting and Leasing 11

Sale and Lease-Back
A particular type of financial
lease
 Occurs when a company sells

an asset it already owns to

another firm and immediately
leases it from them.

Types of Leases 12
Sale and Lease-Back
 Two sets of cash flows occur:
 The lessee receives cash today from
the sale.
 The lessee agrees to make periodic

lease payments, thereby retaining the

use of the asset.

Types of Leases 13
Sale and Lease-Back – An example

14
Leveraged Leases
 A leveraged lease is another type of
financial lease.

 A three-sided arrangement between

the lessee, the lessor, and lenders:
 The lessor owns the asset and for a fee
allows the lessee to use the asset.
 The lessor borrows from lender to

partially finance the asset.

Types of Leases 15
Leveraged Leases
 The lenders typically use a
nonrecourse loan. This means that
the lessor is not obligated to the
lender in case of a default.
 In the event of a default, the lender

has a first lien on the asset. Also,

the lease payments are made
directly to the lender after a
default.

Types of Leases 16
 Leveraged Leases
Lessor buys asset, Firm U leases • Lessor borrows from
lender to partially
it. finance purchase
Manufacturer • The lenders typically use
of asset a nonrecourse loan. This
means that the lessor is
Lessee (Firm U) not obligated to the
lender in case of a
Lessor default by the lessee.
Uses asset
Owns asset • In the event of a default
Not use asset Does not own asset by the lessor, the lender
has a first lien on the
asset. Also, the lease
Equity payments are made
shareholders Creditors directly to the lender
after a default.

Types of Leases 17
The Cash Flows of Leasing
 Consider a firm, ClumZee
Movers, that wishes to acquire a
delivery truck.
 The truck costs $25,000 and has
a useful life of 5 years.
 The truck is expected to reduce
costs by $4,500 per year.
 The before tax cost of secured
debt is 7.57575%.

The Cash Flow of Leasing 18

The Cash Flows of Leasing
 If the firm buys the truck, they
will depreciate it straight-line to
zero.
 Or, they can lease it for 5 years
from Tiger Leasing with an
annual lease payment of $6,250.
 Both ClumZee and Tiger are in
the 34% tax bracket.

The Cash Flow of Leasing 19

 The Cash Flows of Leasing
 Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield 5,000×(.34) = $1,700
–$25,000 $4,670

 Cash Flows: Lease

Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
-$1,155

The Cash Flow of Leasing 20

 The Cash Flows of Leasing
Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 -$1,155 – $4,670 = –$5,825

We could also view the cash flows as buying

minus leasing, which would simply change the
signs on the cash flows.

The Cash Flow of Leasing 21

NPV Analysis of the Lease-vs.-Buy
Decision

 The discount rate is the after-tax

rate on the firm’s secured debt.
A lease payment is like the debt service
on a secured bond issued by the lessee.
 In the real world, many companies

discount both the depreciation tax

shields and the lease payments at the
aftertax interest rate on secured debt
issued by the lessee.

NPV Analysis of the Lease-vs-Buy Decision 22

NPV Analysis of the Lease-vs.-Buy
Decision
 Using the ClumZee Movers example, the
NPV is:

 5825  5825  5825

25000   2
  5
1.05 (1.05) (1.05)
 219.2

NPV Analysis of the Lease-vs-Buy Decision 23

 Does Leasing Ever Pay: The Base
Case
 In our example, ClumZee Movers chose to buy,
because the NPV of leasing is negative (-$219.20)
 Note that this is the opposite of the NPV that Tiger
Leasing would have:
 Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,250×(1 –.34) = $4,125
–$25,000 $5,825

5825 5825 5825

NPV  25000   2
 
1.05 (1.05) (1.05) 5
219.2 24
 A Tax Arbitrage
 Suppose ClumZee movers is actually in the 15%
tax bracket and Tiger Leasing is in the 34% tax
bracket. If Tiger reduces the lease payment to
$6,180, can both firms have a positive NPV?

 Cash Flows: Tiger Leasing

Year 0 Years 1-5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,180×(1 –.34) = $4,078.8
–$25,000
$5,778.8
5778.8 5778.8 5778.8
NPV  25000   2
  5
19.18
1.05 (1.05) (1.05)
Reasons for Leasing 25
 A Tax Arbitrage
 Cash Flows ClumZee Movers: Leasing Instead of
Buying

Year 0 Years 1-5

Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield -5,000×(.15) = –$750
After-Tax Lease Payments -6,180×(1 –.15) = –$5,253
$25,000 –$6,003

 6003  6003  6003

NPV 25000   2
   5
12.59
-14.02
1.064 (1.064) (1.064)

Reasons for Leasing 26

Tiger Leasing’s Breakeven Payment

 What is the smallest lease

payment that Tiger Leasing
will accept? Set their NPV to
zero and solve for $Lmin:

Reasons for Leasing 27

 Tiger Leasing’s Breakeven Payment
Year 0 Years 1-5

Cost of truck -$25,000

Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments $Lmin × (1 –.34) = $Lmin × (1
–.34)
-$25,000 $1,700 + $Lmin × (1
–.34) .66 Lmin  $1,700
5 5
$1,700
NPV 0  $25,000  
(1.05) t
$25,000  t 1 (1.05)
t
t 1
Lmin  5
$1
.66  t
t 1 (1.05)
5 5
$1 $1,700
$25,000 .66 Lmin  t
  t
t 1 (1 .05) t 1 (1 .05) Lmin $ 6,173 .29

Reasons for Leasing 28

ClumZee Mover’s Breakeven Payment

 What is the highest lease payment

that ClumZee Movers can pay? Set
their NPV to zero and solve for
$Lmax:

Reasons for Leasing 29

 ClumZee Mover’s Leasing’s
Breakeven Payment
Year 0 Years 1-5

Cost of truck $25,000

Depreciation Tax Shield -5,000×(0.15) = -
$750
Lease Payments $Lmax × (1 –.15) = $Lmax × (1
–.15)
5
.85  Lmax  $750 -$25,000 -$750 5 -$$L
750max × (1
25,000  
NPV 0 $–.15) t
$25,000   t
(1 . 064 ) t 1 (1.064)
t 1
Lmax  5
$1
.85  t
t 1 (1.064)
5 5
$1 $750
$25,000 .85 Lmax  t
  t
t 1 (1 .064 ) t 1 (1 .064 ) Lmax $66,176
,183.56

Reasons for Leasing 30

Is a Lease Possible?
 The most that ClumZee movers can
afford to pay is $6,183.56
6,176

 The least that Tiger Leasing can

accept is $6,173.29

 So, there could be a lease in this

case.

Reasons for Leasing 31

Key Concepts and Skills
 Compare operating and financing
leases.
 Explain why tax rates affect the
lease vs. buy decision.

32
Back to our case…

33
 Source: http://www.scmp.com/comment/insight-
opinion/article/2096508/hong-kong-will-gain-if-aviation-
leasing-takes-firms-must

Think

about it
To make HK the aviation leasing centre, there should be lessors willing to do this
business and lessees willing to lease rather than buy.
 How tax will affect the willingness of both parties to fall into leasing relationship?

34
Appendix

35
Debt Displacement and Lease
Valuation

 Considering the issues of debt

displacement allows for a more
intuitive understanding of the lease
versus buy decision.
 Leases displace debt:
 Ifa firm leases, it will not use as much
regular debt as it would otherwise.
 The interest tax shield will be lost.

 This is a hidden cost of leasing.

Debt Displacement and Lease Valuation 36

Debt Displacement and Lease
Valuation
 Suppose ClumZee agrees to a lease
payment of $6,250 before tax. This
payment would support a loan of
$25,219.2 (why?).
 In exchange for this, they get the use of a
truck worth $25,000.
 Clearly the NPV is a negative $219.2,
which agrees with our earlier calculations.

Debt Displacement and Lease Valuation 37